Agricultural Futures and Options Key Terms

1. Agricultural Futures and OptionsKey Terms ISQA 458/558 – Food Logistics 12 April 2005

2. Futures Contract • Commitment to make or take a specific quality of a commodity (e.g. #2 yellow corn) and specific quantity at a predetermined time and place in the future • Only variable is price. • Deliveries on futures contracts occur <1% of time

3. Commodity Broker • If you are not a member of the CBOT, you must place trades through a commodity broker, who calls in orders to the exchange and earns a commission in return.

4. Hedge • A counterbalancing investment that involves taking a position in the futures market that is opposite one’s position in the cash market to protect or lock in a price. • Hedging is effective only if cash and futures markets generally move in tandem with each other. • Hedgers generally use the futures contract that immediately follows the time they plan to purchase or sell the physical commodity.

5. Perspectives On Hedging • Tony Flagg, former president of Pendleton Flour Mills noted “by definition a farmer and a consumer cannot hedge”. He said that hedging is a tool used by middlemen, who take a risk and then offset it.

6. CBOT Has More Expansive View Of Hedging • Farmers hedge to protect against declines in prices for crops that are in the ground. • Merchandisers, elevators hedge their profit margin on grains that they buy and later sell or sell and later buy. • Processors and livestock producers hedge to protect against increasing raw material costs or against decreasing inventory values. • Exporters hedge to protect the cost of materials that they have contracted to sell at a later date.

7. Other Definitions • Speculator = Buy or sell futures in order to make a profit on the transaction itself. • Short hedge uses a short futures position to protect against falling commodity prices. • Long hedge uses a long futures position to protect against increasing commodity prices.

8. Other Definitions • Basis = Difference between the cash and futures price. The difference is comprised of variables including freight, local supply and demand, as well as storage and handling costs • Strengthening basis = cash prices increase relative to futures price • Weakening basis = cash price weakens relative to futures price • Flat Price = Futures price + basis.

9. Other Definitions • Option = is the right not an obligation to buy or sell a futures contract at a predetermined price (strike price) at anytime within a specified time period. • Cost of option = the option premium • Enables sellers to establish floor (i.e. minimum) selling prices for protection against falling markets without giving up upside potential in rising markets • Buyers can establish ceiling (maximum) purchase prices for protection against rising markets without giving up savings opportunities in falling markets.

10. Other Definitions • Call option = right to buy underlying futures contract. • Put option = right to sell underlying futures contract. • Option writer = individual who sells either a put or call option in exchange for collecting premium. In exchange for premium, writer bears risk of margin calls and unlimited loss potential.

11. Other Definitions • Premium = intrinsic value + time value • Where intrinsic value = what option is currently worth (based on value of underlying security). • A call option strike price < underlying security price, it has intrinsic value also know as in-the-money. • A put option has intrinsic value if the strike price is > than underlying security price. [Why? You have the right to sell something for say $10 that might really be worth only $5] • Time value = length of time to expiry + volatility.